Fee Speech : Adverse Selection and the Regulation ofMutual Fund Fees 1

The Investment Advisers Act of 1940 (as amended in 1970) prohibits mutual funds in the US from o ering their advisers asymmetric \incentive fee" contracts in which the advisers are rewarded for superior performance via-a-vis a chosen index but are not correspondingly penalized for underforming it. The rationale o ered in defense of the regulation by both the SEC and Congress is that incentive fee structures of this sort encourage \excessive" risk-taking by advisers. This paper uses an adverse selection model with multiple funds and multiple risky securities to study this issue. We nd that incentive fees do, as alleged, lead to more (and suboptimal) risktaking than do symmetric \fulcrum fees." Nonetheless, from the more important welfare angle, we nd that investors may be strictly better o under asymmetric incentive fee structures. Thus, there appears to be little justi cation for the regulation. Adverse Selection and Fee Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1